Want to see your retirement and investment accounts grow? Well, a portfolio’s return is primarily driven by stocks, which also drive the level of risk it is exposed to. So, deciding on an appropriate level of stocks to hold is really important. But, in order to make a thoughtful decision, you must first examine how much risk you’re comfortable with.
Look at the graph below. It is a good starting point for making that decision as it shows the average annual return — as well as the best and worst annual return — for a spectrum of stock and bond allocations over the last 86 years.
As you can see, a portfolio invested in 100 percent bonds (far left side of the chart) over the period shown had an average annual return of 5.5 percent. Not bad. But, a portfolio invested 100 percent in stocks (far right side of the chart) realized an average annual return of 10 percent — nearly double that of all-bonds.
So, what are the real-world differences between the 5 percent portfolio and the 10 percent portfolio over a lifetime? For starters, over the period shown above (86 years) the portfolio that returned 5 percent (all bonds) would have grown a hypothetical $1 to roughly $100. The portfolio that returned 10 percent (all stocks) grew that same dollar to nearly $3,629. That’s a meaningful difference. But where does risk come in to the picture?
There’s the rub. While it’s clear that stocks have made the most money, there has been a “cost” involved.
Look at the 100 percent stock bar on the chart once again. Like Slim Pickens riding the nuke at the end of Dr. Strangelove, the stock allocation really has had a wild ride. While the very best single year offered an eye-popping gain 54.2 percent, there have also been individual years where stocks lost as much as 43 percent. And to complicate matters, markets have declined for a number of successive years in a row on many occasions.
Those losses can add up, both economically and emotionally. It’s difficult to convey on paper the stress and fear that can accompany a really bad year(s) for stocks, especially when it’s your portfolio, retirement and future lifestyle that seems to be going down the tube. Such periods are terribly difficult to endure without blinking. And just in case you have forgotten what has happened to stocks say, even over just the last decade, here’s a quick reminder.
Remember that the next time stocks blow it out to the upside. In order to match that return for your entire portfolio, you would of course have to be entirely invested in stocks. And if you think you want to go that route, unless you know of some way of hearing the proverbial bell ringing at the top, you had better resign yourself to the full ride. Mid-stream allocation readjustments made on gut, chance or fear, rarely make for a good long-term plan.
If you don’t want to expose yourself to the full brunt of the bad markets, here’s (again) a suggestion. Consider a diversified and balanced approach. A split of say 60 percent stocks and 40 percent bonds is often a good starting point. Such an allocation would have offered an average return of nearly 9 percent over the last 86 years — not so terribly different from that of the all-stock figure, but with a much smoother ride along the way. And that smoother ride would have made it all the easier to stay put during the recurrent tough markets experienced, as well as those yet to come.
This article is titled “Steak or Beans.” That is not to imply that your financial well-being completely depends on how aggressive or conservative you are. Quite the contrary.
Both have their place, and both are good, depending on your age and station in life. Rather, what really puts a dent in your wallet is not properly thinking about, and planning for, risk before the storm.
So examine the first chart carefully as you work through this. The last thing you want to experience is inadvertently taking on more risk than realized when times are good, only to later find that you’re holding a hot potato and sell out at a loss. That’s when not properly planning can really hurt.